Tuesday, May 18, 2010

PIMCO Chief Issues Warning On Global Debt Crisis

"First and foremost, [the Europeans] have to understand how urgent the situation is. The crisis in Greece is morphing very quickly. It went from being a public finance issue in Greece to being now something that's impacting the periphery as a whole. It went from being something that was dealing just with the budget. Now there's a risk that it becomes a banking crisis. And it went from something that could be handled by bailing in the private sectors through new flows, to now concerns about restructurings. So the most critical thing is for the European to understand that when you allow a crisis to fester it morphs, and it morphs into something much more difficult to control." – Mohamed El-Erian, April 29, 2010

Mohamed El-Erian is the CEO of PIMCO, the world's biggest bond fund. On May 7, he wrote an editorial that was published both on the PIMCO website and in Financial Times. It was notable for its many keen insights and observations.

With a pedigree that includes a doctorate in economics from Oxford, a former faculty position at Harvard Business School, and 15 years at the IMF, when Dr. El-Erian speaks, people have a tendency to listen.

In his editorial, Dr. El-Erian noted that current debt problems "are not limited to Europe" and that, "It is only a matter of time" before this issue begins to shape government policies and the market valuations of sovereign debt.

In essence, what he's saying is that, like Greece, governments around the will be forced to make uncomfortable budget cuts that will affect the social fabric of their nations. And how markets assess those spending reductions, and assign risk to government debt, will affect bond yields.

Dr. El-Erian calls the crisis facing industrial countries a "sovereign debt explosion" and says the effects will be both "consequential" and "long-lasting." In his view, most countries in the world will feel "aftershocks" from what is happening in Greece.

Specifically, trade will be affected as international demand slows, putting a drag on any global economic recovery. In Dr. El-Erian's view, this will also complicate the ability of the private sector to step in and takeover from governments that have used deficit spending to stimulate their economies and prop up demand.

Countries that rely heavily on exporting to the eurozone will be particularly affected. Yet, some countries, such as the US, are poised to see foreign capital flows increase as investors seek to diminish risk and volatility.

In a normal world, investors would be running like hell from the US and it's persistent deficits and debt. Despite an unsustainable long term debt, and deficits reaching 10% of GDP this year and 11% next year, investors will nonetheless follow their usual instincts and past patterns of behavior, flocking to US dollars and assets.

Because the dollar is still the world's reserve currency, and because of the historic position of the US in the global economy, the herd will continue to revert to their knee-jerk behavior — for the time being, at least.

Dr. El - Erian notes that Greece is not a unique problem, but is representative of massive sovereign debts around the world. Because of this, he warns that we should also expect a "generalised and volatile" increase in risk around the world. Higher interest rates on government debt will not attract investors, who will instead seek "liquidity over returns and safe government bonds over equities."

This means we can expect stock markets to continue their volatility and downward trends.

Of equal concern, Dr. El -Erian says the European banking system is at risk due to uncertainties about each institution’s exposures to sovereign debt, as well as their links to one another.

The close links between US and European banks cannot be overlooked either.

So, where does all this leave us?

"The Greek crisis has already morphed into a regional (eurozone) shock," wrote El-Erian. "It now stands on the verge of morphing into a more global phenomenon."

The previous day, May 6th, as world markets were tumbling, Dr. El-Erian had this powerful warning for the US:

"We are not Greece. We have more time. But what the Greek crisis tells you is debt and deficits matter," El-Erian said. "The structure of your deficits matter and the US doesn't have much flexibility."

"Don't underestimate how quickly this can happen," he added. "There are structural headwinds out there and we better get our act together before those structural headwinds become overwhelming."

The US faces long term, structural deficits that are the result of an aging population that vastly outnumbers its working population. Younger workers are paying the Social Security and Medicare costs of older Americans. The government has little flexibility here.

In fact, most of the Federal Budget is non-discretionary, made up of Social Security, Medicare, interest on the debt (which isn't negotiable), and — believe it or not — and agricultural subsidies. These things are all mandated by law. Add in military and war costs, and you're up to two-thirds of the budget. Defense spending is, however, discretionary.

So, other than military spending — which most politicians are loathe to cut — only 16% of the Federal Budget is discretionary, meaning we're just tinkering at the edges.

There is little flexibility, and cutting military spending or any of the mandatory programs would be politically unpopular. Most politicians aren't known for their courage, or their willingness to make tough, unpopular choices.

And that's why our deficit and debt problems are so daunting,

That said, we've been warned.

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